Italy: Selected Issues
Author: International Monetary Fund. European Dept.
Publication Date:
27 Jul 2017
eISBN:
9781484312568
Language:
English
Keywords:
ISCR; CR; real GDP; GDP; Italy; dividend; tax credit; steady-state real GDP; IMF's contribution; policy package; monopolistic competition; Structural reforms; Nonperforming loans; Wage bargaining; Total factor productivity; Fiscal consolidation; Global
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Selected Issues

Abstract

Selected Issues

Quantifying the Benefits of a Comprehensive Reform Package1

This note seeks to quantify the net benefits of a comprehensive reform package aimed at addressing Italy’s inter-related challenges. Specifically, it simulates the growth and competitiveness effects of a package of fiscal, financial, wage bargaining, and other structural reforms. Credible implementation of such a package yields substantial medium-term dividends at negligible near-term growth costs. Real GDP growth is estimated to be substantially higher over the medium term, while the real effective exchange rate depreciates notably.

A. Background

1. Italy is struggling with modest growth, high public debt, and a banking system burdened with high nonperforming loans and weak profitability. The economic recovery is being weighed down by long-standing structural problems, imbalances, and strained balance sheets. At the same time, restoration of balance sheet health is being hindered in important part by the slow economic recovery. On current projections, growth remains too modest to decisively reverse imbalances and lower debt, leaving the economy vulnerable to adverse developments.

2. Relatedly, Italy’s competitiveness is assessed to be moderately weaker than suggested by medium-term fundamentals and desirable policy settings. The current account surplus that emerged since 2013 has mostly been the result of import compression caused by a decline in investment and large commodity terms of trade gains. The recovery of exports has lagged, while desirable policy settings to reduce high public debt and medium-term fundamentals, including Italy’s rapidly aging society, imply a higher equilibrium current account balance. Unit labor costs that rose notably in the years following euro accession remain elevated, as wage gains have outstripped productivity. The real exchange rate is estimated to be overvalued on the order of 10 percent.2

3. Fostering growth and competitiveness and addressing imbalances requires a comprehensive and timely policy response. Such a response would not only address underlying rigidities and imbalances and, thus, unlock growth, but also ensure that public debt and bank nonperforming loans (NPLs) are placed on a firm downward trajectory over the medium term. It could include (i) fiscal consolidation, underpinned by growth-friendly and inclusive measures (see SIP Part 2); (ii) wage bargaining reforms to ensure wages are aligned with productivity at the firm level (see SIP Part 1); (iii) other structural reforms (e.g., product market, other supportive labor market reforms, and public administration reforms); and (iv) financial sector measures to hasten the cleanup of bank balance sheets and corporate restructuring.

B. Reform Program

4. This note uses the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) to simulate the impact of key fiscal and structural reforms on output and competitiveness (Box 1). As the GIMF incorporates monopolistic competition and a rich set of structural rigidities, it can be used to assess the effectiveness of structural reforms. In doing so, this note relies on the distance-to-frontier approach whereby the gap between Italy and the euro area frontier is assumed to be narrowed over the medium term.3 GIMF also has a well-developed fiscal block allowing for the analysis of fiscal instruments. All other structural policies are phased in over a 5–10-year horizon in a step-wise manner, becoming fully implemented and credible at the fifth year.

5. Several research papers over the past few years provide guidance on mapping reforms to GIMF. While the fiscal block in GIMF allows a direct relation to fiscal policies, simulating structural and financial reforms requires mapping reform intentions to changes in GIMF structural parameters (such as wage and price markups, labor supply, total factor productivity or TFP, etc.). A growing body of literature on macro-structural and macro-financial interlinkages provides quantitative guidance for such mappings. Table 1 summarizes all shocks, instruments and sources for mapping.

6. The proposed policy package is as follows:

  • Fiscal adjustment and rebalancing. To achieve a small structural surplus, which for simplicity is modeled as a fiscal consolidation of 2 percent of GDP over four years, a growth-friendly and inclusive policy mix is envisaged. This is assumed to comprise a revenue-neutral and less distortionary tax reform to reduce the labor tax wedge by 1½ percent of GDP, financed by lower VAT gaps, both compliance and policy, (1 percent of GDP); a property tax on primary residences (½ percent of GDP); current primary spending cuts, achieved by reducing large social benefits and spending on goods and services, both by 1¼ percent of GDP; and increasing spending on public capital by ½ percent of GDP (see SIP Part 2).

  • Wage bargaining. To facilitate the alignment of wages with productivity at the firm level, a move from the current sectoral-level to firm-level wage setting is assumed (see SIP Part 1). By aligning the wage distribution closer with the productivity distribution of firms, decentralized bargaining could save (create) jobs that otherwise would be destroyed (or not created). As shown in SIP Part 1, simulations of such a reform calibrated to the Italian labor market point to an increase in steady-state employment of about 4 percent from such a reform. This result is replicated in GIMF via a reduction in the wage markup by about 15 p.p.

  • Other structural reforms.

    • Labor market reforms. Measures to incentivize labor force participation and improve targeting of social spending in a fiscally-neutral manner include (i) scaling up active labor market policies (ALMPs, 0.4 percent of GDP); (ii) increasing spending on childcare (0.2 percent of GDP); and (iii) broadening the social safety net to cover all those below the poverty line (0.5 percent of GDP). These reforms are modelled as a neutral spending reallocation from general (untargeted) to targeted transfers phased in over five years. The effect of these reforms on labor supply is derived from estimates developed by the OECD, including for the IMF’s contribution to the G-20 Mutual Assessment process (see IMF, 2011; Barnes, 2014).

    • Product market reforms. The reform envisages further easing of regulatory barriers to competition in sectors such as retail trade, professionals, and select network sectors (e.g., road and local transport services) that remain more highly regulated than the euro area frontier, defined as an average of the five best OECD Energy, Transport, and Communications Regulation (ETCR) scores. It is assumed that the distance-to-frontier is closed by one-half, resulting in an equivalent improvement in a non-tradable product market regulation (PMR) score by about 17 percent, and phased in over 5–10 years. The phasing as well as mapping into a non-tradable TFP shock4 follows OECD estimates of the reform impact (see Barnes, 2014).

    • Public administration reforms. Public sector efficiency and firm productivity vary widely across Italian provinces (OECD, 2017). Giordano and others (2015) calculate public sector efficiency as a distance to the efficiency frontier in five key public service sectors—health, education, civil justice, child care, and waste collection—across 103 Italian provinces, using non-parametric Data Envelopment Analysis. They find that an increase in public sector efficiency in all provinces to the frontier would expand output for an average firm by 3 percent. Given that public-sector efficiency—as institutions—are slow to change, it is assumed that about one-half of the distance to frontier will be closed, by means of an economy-wide TFP shock.

  • Banking sector clean-up. High NPLs are a drag on bank profitability and economic activity by requiring greater loan-loss provisions, which reduce the resources available for lending, and diverting resources and attention away from extending new credit to internal consolidation and asset quality (see Peek and Rosengren, 2005; and Caballero and others, 2008).

    • Using a newly constructed dataset on NPL reduction episodes, Balgova and others (2016) illustrate that a reduction in NPL ratios leads to faster GDP growth, higher credit growth and investment, and better labor market outcomes. Following Mohaddes and others (2017), the impact of a change in the NPL ratio on long-term real GDP growth is estimated—mean reverting the NPL ratio to normal levels (around 5–6 percent) would lead to a 3 percent higher real GDP in the long run (see Table 1). All the estimates are negative (about –0.08) and statistically significant at the 1 percent level, suggesting that a 5 percent persistent increase in the NPL ratio per year (observed in Italy since 2000 on average) is associated with 0.4 percentage points lower annual GDP growth in the long run, on average.

    • Correspondingly, reducing the NPL ratio to normal levels in five years and sustaining them at that level should imply higher real GDP by about 2 percent in five years and around 3 percent in steady state. This finding is mapped into GIMF—to allow for cumulating the effects of the reform package in a single framework—via a TFP shock that is distributed about ¾ into the non-tradable and ¼ into the tradable sector. In practice, this modeling assumption within the GIMF framework (which does not have banks) can be thought of as recovering value from existing stock of NPLs, e.g., through accelerated insolvency and workout procedures, rather than through higher upfront provisioning or capital costs.

Estimates of (Mean) Long-run Effects of Changes in the NPL Ratio on Real GDP Growth (1997–2014)

article image
Notes: Standard errors are provided in parentheses. All estimates are statistically significant at the 1% level.

C. Results and Policy Discussion

7. The reform package potentially increases output by 6–13 percent above the baseline and delivers a notable REER depreciation. Figures 1–4 show individual simulation results for the above-mentioned reform blocks. The cumulative results are shown in Figure 5. About one-half of the competitiveness gains over the medium term stem from structural reforms and, in particular, wage bargaining. This is consistent with the finding that increases in the hourly wage rate accounts for a large part of the ULC-gap against euro area peers (see SIP Part 1). The other half comes from growth-enhancing fiscal devaluation, spending rebalancing, and the cleanup of bank balance sheets.

A03ufig1

Real Effective Exchange Rate

(Percent deviation from baseline; “+”=appreciation)

Citation: IMF Staff Country Reports 2017, 238; 10.5089/9781484312568.002.A003

Source: IMF staff estimates.Notes: Horizontal axis=years, and SS = steady state. Lines are stacked so that blue shows also total impact.

8. The medium-term output gains are substantial, while the short-term output losses are very limited. Upfront implementation of structural reforms is supportive of growth in the near and medium terms and helps offset the relatively small initial output losses associated with the fiscal consolidation. By itself, fiscal consolidation results in lower real GDP that, at its peak, is about % percent below baseline after three years. However, taken together with upfront implementation of structural reforms and bank balance sheet cleanup, these costs are offset.

9. In practice, the yields from the comprehensive reform package outlined above may be smaller. Model uncertainty, measurement error, interim economic shocks, implementation challenges, and the like may reduce the yields of the above comprehensive policy package. Thus, it may be more prudent to conclude that growth over the medium term would increase at best by the amounts estimated above.

A03ufig2

Real GDP

(Percent deviation from baseline)

Citation: IMF Staff Country Reports 2017, 238; 10.5089/9781484312568.002.A003

Source: IMF staff estimates.Notes: Horizontal axis=years, and SS=steady state. Lines are stacked so that blue shows also total impact.

The Global Integrated Monetary and Fiscal Model (GIMF)

The IMF’s Global Integrated Monetary and Fiscal (GIMF) model is used to quantify the effects of reforms—see Kumhof and others (2010) and Anderson and others (2013) for more details.

GIMF is a multi-country structural dynamic general equilibrium model featuring Italy, the rest of the euro area, and the rest of the world. It links the behavior of households, firms, and government sector within and among countries. The model has a consistent system of national accounting and stock-flow budget constraints for all sectors, including the government. The model belongs to exogenous-growth types of models, meaning that the long-term growth of output is exogenous. Hence, all fiscal or structural measures may change only the structure of the economy, possibly increasing permanently the level of real output per capita; never long-term growth.

The household sector consists of forward-looking optimizing households, as well as liquidity-constrained households who spend all their available income every period. The forward-looking households are modeled as overlapping generations (OLG) with finite lives, following the Blanchard-Weil-Yaari framework. The presence of OLG households breaks the Ricardian equivalence and is important for realistic results of fiscal policy in both the short and long run. Households gain utility from consumption and disutility from labor effort, they consume traded and non-traded services and goods, receive labor income, transfers from the government, dividends from corporations, and pay taxes—income, consumption, and lump-sum taxes.

Firms produce intermediate and final goods using labor and capital inputs, accumulate capital, and import or export their production. Firms pay taxes from corporate income. Monetary policy in the euro area and rest of the world regions follows an inflation-forecast targeting rule to set policy interest rates. Italy is a member of the euro area.

Government collects tax revenues (consumption, labor income, capital income, and lump-sum taxes) and spends them on government consumption, investment, and transfers to households. Governments target specific debt-to-GDP (and thus deficit-to-GDP) ratios and use a mix of instruments to achieve it. The government’s commitment to sustainable public finance is credible for firms and households, who hold the stock of government bonds.

Figure 1.
Figure 1.

Italy: Fiscal Reform

Citation: IMF Staff Country Reports 2017, 238; 10.5089/9781484312568.002.A003

Source: IMF staff estimates.Notes: Horizontal axis=years, and SS=steady state. Red: revenue rebalancing. Blue: total impact.
Figure 2.
Figure 2.

Italy: Wage Bargaining

Citation: IMF Staff Country Reports 2017, 238; 10.5089/9781484312568.002.A003

Source: IMF staff estimates.Notes: Horizontal axis=years, and SS=steady state. Blue: total impact.
Figure 3.
Figure 3.

Italy: Other Structural Reforms: Product Markets, Public Sector Efficiency, Guaranteed Minimum Income, ALMPs, and Child Care

Citation: IMF Staff Country Reports 2017, 238; 10.5089/9781484312568.002.A003

Source: IMF staff estimates.Notes: Horizontal axis=years, and SS=steady state. Blue: total impact.
Figure 4.
Figure 4.

Italy: NPL Reduction

Citation: IMF Staff Country Reports 2017, 238; 10.5089/9781484312568.002.A003

Source: IMF staff estimates.Notes: Horizontal axis=years, and SS=steady state. Blue: total impact.
Figure 5.
Figure 5.

Italy: Total Reform Package

Citation: IMF Staff Country Reports 2017, 238; 10.5089/9781484312568.002.A003

Source: IMF staff estimates.Notes: Horizontal axis=years, and SS=steady state. Blue: total impact.
Table 1.

Italy: GIMF Simulation Strategy

article image

References

  • Anderson, D., Hunt, B., Kortelainen, M., Kumhof, M., Laxton, D., Muir, D., Mursula, S. and S. Snudden, 2013, “Getting to Know GIMF: The Simulation Properties of the Global Integrated Monetary and Fiscal Model,” IMF Working Paper WP/13/55 (Washington: IMF).

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  • Andrle, M., Hebous, S., Kangur, A., and M. Raissi, 2017, “Italy: Toward a Growth-Friendly Fiscal Reform,” (forthcoming).

  • Balgova, M., M. Nies, and A. Plekhanov, 2016, “The Economic Impact of Reducing Nonperforming Loans,” EBRD Working Paper Number 193.

  • Barnes, S., 2014, “Reforms and Growth: A Quantification Exercise,” OECD, Nero Meeting.

  • Caballero, R. J., T. Hoshi, and A. K. Kashyap, 2008, “Zombie Lending and Depressed Restructuring in Japan,” American Economic Review, Vol. 98(5), pp. 1943–77.

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  • Giordano, R., Lanau, S., Tommasino, P. and P. Topalova, 2015, “Does Public Sector Inefficiency Constrain Firm Productivity: Evidence from Italian Provinces,” IMF Working Paper No. 15/168 (Washington: IMF).

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  • IMF, 2011, “G-20 Mutual Assessment Process: From Pittsburgh to Cannes—IMF Umbrella Report” (Washington).

  • IMF, 2017, “2017 External Sector Report,” IMF Policy Paper (forthcoming).

  • Jimeno, F.J. and C. Thomas, 2013, “Collective Bargaining, Firm Heterogeneity and Unemployment,” European Economic Review, Vol. 59, pp. 63–79.

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  • Kangur, A., 2017, “Competitiveness and Wage Bargaining Reform in Italy,” (forthcoming).

  • Kumhof, M., Laxton, D., Muir, D. and S. Mursula, 2010, “The Global Integrated Monetary and Fiscal Model (GIMF)–Theoretical Structure,” IMF Working Paper No. 10/34 (Washington: IMF).

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  • Lusinyan, L. and D. Muir, 2013, “Assessing the Macroeconomic Impact of Structural Reforms: The Case of Italy,” IMF Working Paper No. 13/22 (Washington: IMF).

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  • Mohaddes, K., Raissi, M. and A. Weber, 2017, “Can Italy Grow Out of Its NPL Overhang? A Panel Threshold Analysis,” IMF Working Paper No. 17/66 (Washington: International Monetary Fund).

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  • OECD, 2017, “OECD Economic Surveys: Italy 2017” (OECD Publishing: Paris). http://dx.doi.org/10.1787/eco_surveys-ita-2017-en

  • Peek, J. and E. S. Rosengren, 2005, “Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan,” American Economic Review, Vol. 95(4), pp. 1144–1166.

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1

Prepared by Michal Andrle (RES), Alvar Kangur, and Mehdi Raissi (both EUR). Comments from the Italian authorities are gratefully acknowledged.

2

IMF, “2017 External Sector Report,” IMF Policy Paper (Washington, 2017).

3

Lusinyan and Muir (2013) conduct a similar exercise while quantifying the impact of the authorities’ structural reform program at the time.

4

TFP shock has quantitatively similar properties compared to a price-markup shock.

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Cover IMF Staff Country Reports
Italy: Selected Issues
Author: International Monetary Fund. European Dept.
Volume/Issue:
Volume 2017: Issue 238
Publisher:
International Monetary Fund
ISBN:
9781484312568
ISSN:
1934-7685
Pages:
80
DOI:
https://doi.org/10.5089/9781484312568.002

Real Effective Exchange Rate

(Percent deviation from baseline; “+”=appreciation)

Real GDP

(Percent deviation from baseline)

Italy: Fiscal Reform

Italy: Wage Bargaining

Italy: Other Structural Reforms: Product Markets, Public Sector Efficiency, Guaranteed Minimum Income, ALMPs, and Child Care

Italy: NPL Reduction

Italy: Total Reform Package